Efficiency, Risk and the Gains from Trade in Interbank Markets

Abstract

Bank-to-bank markets play a central role in liquidity provision. However, by propagating shocks between banks, they may be a source of aggregate risk. We develop a quantitative framework to capture the welfare trade-off between efficiency and risk accompanying interbank market integration. In the model, we derive analytical approximations for welfare that depend on features of the interbank network and few key elasticities, we estimate using microdata on bilateral asset positions for the population of German banks. Our findings indicate that the current level of integration improves welfare by 1.33\%, while lender-of-last-resort policies reduce the welfare costs of short-term financial shocks.

Keywords: Bank Networks, Interbank Markets, Trade, Lender-of-last-resort